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August 1, 2012

Jeremy Grantham: Today a Food Crisis, Tomorrow ‘Dystopia’

High-performing hedge fund manager Jeremy Grantham is known for his doom-and-gloom outlook. But his latest shareholder letter, called “Welcome to Dystopia”, updates the merely “terrifying” problems of eurozone financial contagion and U.S. debt with worldwide instability and social collapse.

In his February quarterly letter, Grantham (left) urged investors to “try to contain natural optimism”; in December, he warned the U.S. was falling behind other developed nations, even the U.K. Consistently, he has urged investors to be overweight natural resources.

Though he stands by his resource recommendation, Grantham’s current thinking is not quite as cheerful as in the past. This is largely because the new era (beginning 10 years ago) of rising resource prices he started writing about a year ago has been aggravated by what he sees as the start (five years ago) of a full-blown food crisis.

The current spike in corn prices is more worrisome than the previous 2008 food crisis because the poor U.S. crop yield comes despite “very much larger plantings than were available in 2008.” What’s more, this is the third consecutive year of extremely bad weather, the improbability of which Grantham takes as confirmation of climate change.

Grantham brings the case of Egypt as emblematic of the mathematical inescapability of crisis. The strategically important Middle Eastern country is already staggering under rising food prices that consume more than 40% of its food budget (in contrast to the 10% or 12% of developed-country budgets).

Now, declining crop yields combined with rising demand resulting from global population growth suggest the possibility that grain prices could double in the next 20 years.

While that would be “painful indeed even for rich countries,” for a country like Egypt whose population of 84 million is expected to swell to 140 million by 2050, “any material increases in real grain prices from here on are unlikely to be easily manageable,” Grantham writes.

The hedge fund manager concludes: “If you realize that several countries are in [Egypt’s] position and quite a few are worse off, then you realize how perilously thin the veneer of global stability is.”

Grantham believes sufficient efforts to stem a food crisis will not be taken. “This is because the price signals for the rich countries are too weak—they can afford the higher price… Also, the problems of malnutrition in distant countries are not generally felt as high-order priorities in the richer countries.”

The 16-page letter goes into far greater detail about natural resource troubles. While food crisis is the biggest theme, Grantham foresees the current availability of water, energy and metals morphing into long-term squeezes that are dire (“metals are the most intractable problem…we will just slowly run out and prices will rise”).

The upshot of this resource crisis, particularly food, is a dystopian future of human misery, including “waves of immigration on a scale unknown in modern times, outside of major wars” as well as increased military confrontation. “China, more concerned with future resource security than others, will find it particularly tempting to throw its increasing economic and military weight around,” Grantham writes.

The investment implications of all this is that “serious long-term investors should have a very substantial overweighting in a resource package,” by which Grantham means at least 30% in natural resources. He adds that “the quality group of equities” is more resilient to margin pressures from higher priced resources.

He recommends that half of that 30% resource package should go to forestry and farms, with the remaining allocation going to “stuff in the ground” (10%) and resource efficiency plays (5%).

Interestingly, Grantham excludes coal and tar sands from his “stuff in the ground” allocation—less because their environmental impact troubles his conscience than that their increasingly apparent environmental damage will curtail their use, he says.

The hedge fund manager concludes with a further unpleasant thought for investors: that rising resource prices, which would bolster his strong resource allocation, will squeeze profits and reduce growth in the rest of the portfolio. He promises to elaborate in his next letter on the “serious implications for longer-term endowment and pension fund returns.”